Smith Maneuver – Making Mortgage Interest Tax Deductible in Canada

The Smith Maneuver, popularized by Canadian Fraser Smith, is a basic strategy for Canadians who, unlike our American friends, cannot deduct mortgage interest from their personal income. This means that the average Canadian must pay their mortgage with after-tax dollars. With personal tax rates as high as 39% in Canada, having mortgage interest as a tax deduction could provide a significant benefit. This is where the Smith Maneuver comes into play.

Canada Revenue Agency rules permit that interest costs incurred on money used for investment is fully tax deductible. Simply put, interest charges on borrowed money, from a home equity line of credit (HELOC) that is used to invest, is fully tax deductible.

So What’s the Catch?

There really isn’t one, with the exception of how the Smith Maneuver is typically employed. Most financial planners will encourage a client to take an interest-only loan or credit line in second position on their home. This borrowed money, that at most requires only a minimum interest payment monthly, is then used to purchase stocks, bonds or mutual funds.

Here is where the problem lies—the purchaser must pay interest on the loan, and in most cases this is out of household, after-tax cash flow, which immediately cuts into the gross return. It is our experience that some local credit unions will actually capitalize your payments until the mortgage component is paid in full, but many banks will not.

There is an immediate tax savings realized from both the investment and from the interest charges on the borrowed money. However, the invested capital must be realized at some point, taxed, and used to pay off the loan that has been serviced on interest payments for the duration of the loan (upwards of 22.25 years if the Smith Maneuver was implemented at day 1 of a 25 year amortizing mortgage). The example in Figure 3.2 of the book The Smith Maneuver illustrates The Blacks, on the common version of the Smith Maneuver would reduce their tax bill by $41,980 over this time period and 2.75 years off of their 25-year mortgage.

Sounds good so far, but they have an investment portfolio of $309,882, which they now need to liquidate to pay off their original loan—oh, and pay tax on the capital gain. Even if a modest 32% tax rate was applied to this as a capital gain (and capital gains taxed at 50% of the 32%- or 16%), there is a tax bill the year of realizing the capital. This could amount to approximately $49,581 on the $309,882. This is another side of the tax equation, which in many cases is not discussed with the client; plus the actual cash flow required to support the investment loan while it was out can come as a shock.

Other Factors to Consider with the Smith Maneuver

In addition, there are other factors involved in the Smith Maneuver, such as inflation, the cash savings of mortgage prepayment from saved interest charges, shorter amortizations and interest only loans that capitalize the payment at the end of the term. This represents only one understanding and interpretation of how the Smith Maneuver is applied. It is not intended as financial advice, but rather to illustrate that there are more sides to the coin in the most common way the Smith Maneuver seems to be applied.

Using Borrowed Funds to Invest – Is the Smith Maneuver a Good Idea?

Does this mean that using borrowed funds to invest is a bad idea? No, not at all. What is does mean is that your investment vehicle needs to offer better tax advantages during the investment, offer a better tax position exit or capitalization of the asset, and should generate larger returns than the 10% example in the book. What would be even better is if the asset did not have to be sold, but rather could be leveraged or generate income by itself. On its own, the Smith Maneuver is a basic financial tool to pay off a mortgage quickly, but does little to generate substantial wealth. The answer? Real estate.

Smith does touch the use of real estate and corporations in his book. We would suggest this be taken one step further to include real estate held within a properly structured real estate corporation and with appropriate tax accounting in place. This is an excellent way to leverage capital, debt service the capital (through rents), generate cash flow (through rents) and preserve the asset in perpetuity, rather than having to liquidate to generate capital or cash flow.

MBN Mortgage in Calgary, Alberta – Making Sense of it All

It may seem complicated, but we can help you navigate your way through. For a complimentary meeting or to attend a free seminar to learn more about the benefits of leveraging your investment dollars in real estate, please give us a call or fill out our contact form.